MODULE 2

COSTING IN AN ENTITY

WHAT IS COSTING?
➢ Method of Determining Cost of Products &
Services
WHY IS IT IMPORTANT?
➢ Help management plan & control operations
(budgeting)
➢ Make effective pricing decisions.
Prepared by: Gerald Peries 1
 IMPORTANT TERMS IN
COSTING
COST
➢Amount of expenditure incurred on
activities , products or services
COST UNIT
➢Unit of product or service in relation to
which costs can be ascertained
➢Example : Cost per job, cost per contract,
cost per book,cost per participant, cost per
patient day, etc.
Prepared by: Gerald Peries 2
 IMPORTANT TERMS IN
COSTING (Continued)

COST CENTRE
➢ Division of business into sections where costs can
be charged
➢ Example: packing department, assembly
department, painting department, claim
processing department, etc

Prepared by: Gerald Peries 3

 FLOW OF COST

Cost Centre X Cost Cost

COSTS charged Cost Centre Y absorbed Units Per
to Cost Centre Z by Unit

Prepared by: Gerald Peries 4

 CLASSIFICATION OF
COSTS
PRODUCTION COST Consists of:-

DIRECT COST

DIRECT MATERIALS
➢ Materials than can be physically identified with
finished product or service
➢ Example : Notes for participants, Wood to make
table, tyres for cars, diesel for lorry, coal for
power plant, medicine to patients, etc
Prepared by: Gerald Peries 5
MANUFACTURING COST
(CONTINUED)
DIRECT LABOUR
➢ Labour costs that can be traced to or identified
with a finished product/service
➢ Example : Salary of worker who assembles
tables, production operators, trainers/lecturers, etc
OTHER DIRECT COST
➢ Example : Royalty payment
DIRECT MATERIAL + DIRECT LABOUR+
OTHER DIRECT COST = DIRECT COST

Prepared by: Gerald Peries 6

 INDIRECT COST
➢ Cannot be easily traced to a finished product or service
PRODUCTION OVERHEAD
➢ Example : Depreciation of factory equipment, medical
equipment, supervisor’s salary, etc

NON-PRODUCTION OVERHEAD
➢ Selling, distribution & admin. cost
➢ Example: Advertising, transport of finished product,
office salaries, etc

Prepared by: Gerald Peries 7

 CLASSIFICATION OF
COSTS (Continued)

CONVERSION COST
Cost of converting raw materials into finished
products/service
CONVERSION COST = DIRECT
LABOUR + PRODUCTION OVERHEAD

Prepared by: Gerald Peries 8

 SUMMARY OF COSTS
Direct Material
+ Direct Labour
= Direct Cost
+ Production O.H.-Indirect cost
= Total Production Cost
+ Non-Production O.H -Indirect cost
= Total Cost

Prepared by: Gerald Peries 9

 PRODUCT & PERIOD COST

PRODUCT/SERVICE COST
➢Cost that can be identified with the product/service
➢Necessary & integral part of producing finished
product or of providing the service
➢Include direct material, direct labour & operation
overhead
PERIOD COST
➢Cost identified with a specific time period includes
non-production overhead like advertising, selling
& admin. cost
Prepared by: Gerald Peries 10
 COSTING SYSTEMS
SPECIFIC ORDER COSTING
➢ Work consists of separate contracts, jobs or
batches.
➢ Each authorised by a special order or contract.
1) JOB COSTING
➢ Work done according to customer’s order
➢ Example : Renovation of house, manufacturing
specialised drills, etc.
2) BATCH COSTING
➢ Similar products manufactured in batches.
➢ Example : 500 wedding cards, text books,
brochures etc.
Prepared by: Gerald Peries 11
SPECIFIC ORDER COSTING
(Continued)
3) CONTRACT COSTING
➢ Similar to job costing
➢ But cost unit is very large
➢ Takes long time to complete
➢ Construction type jobs
➢ Example : Construction of highway,
pipeline etc.

Prepared by: Gerald Peries 12

 COSTING SYSTEMS
(Continued)
OPERATION COSTING
➢Repetitive or continuous operation
➢Standardised goods or services
1) PROCESS COSTING
➢Goes through a series of processes
➢Example : Refining of petrol, manufacturing
soap powder, cereal, cars etc.

Prepared by: Gerald Peries 13

 OPERATION COSTING
(Continued)
2) SERVICE COSTING
➢ Usually standardised services provided
➢ Objective is to find cost of service provided
➢ Example : Consultation, bus service,
hospitals, education, etc.

Prepared by: Gerald Peries 14

 ALLOCATION & APPORTIONMENT
OF OVERHEADS TO COST CENTRES

ALLOCATION OF OVERHEADS
➢ Charging overhead costs directly to cost
centres, where possible.
Examples :-
EXPENDITURE COST CENTRE
Lubricating oil Machine shop
Repairs to shelves Stores

Prepared by: Gerald Peries 15

 APPORTIONMENT OF
OVERHEADS
➢ When allocation not possible
➢ Apportionment of overheads on equitable
basis:- EXPENDITURE

ALLOCATE APPORTION

DIRECT OVERHEADS OVERHEADS

COST (CAN BE TRACED (NOT SUITABLE
TO COST CENTRE) FOR ALLOCATION)

Prepared by: Gerald Peries 16

 BASIS OF APPORTIONMENT OF
OVERHEADS (Continued)
➢Example of Basis of Apportionment:
BASIS OF
APPORTIONMENT
OVERHEAD TO COST CENTRES
Building: Rent, Tax Floor area of each cost centre
Maintenance & Insurance
Electricity Charges Volume of space or floor area
Depreciation of Plant, Cost or book value of item
Machinery & Equipment in cost centre.

Prepared by: Gerald Peries 17

 BASIS OF APPORTIONMENT OF
OVERHEADS (Continued)
➢ Example of Basis of Apportionment:
BASIS OF
APPORTIONMENT
OVERHEAD TO COST CENTRES
Insurance of Plant, Cost or replacement value of
Machinery & Equipment item in cost centre.

Cost of Storekeeping No. of requisitions issued

Prepared by: Gerald Peries 18

 EXAMPLE OF APPORTIONMENT OF
OPERATION O.H.
Maju Bhd. is a company with four production cost centres:
cost centre 1, 2 ,3 & 4. The following data relates to the four
cost centres (hereafter referred to as CC):

CC1 CC2 CC3 CC4 TOTAL

Floor area (Metres2) 2,000 1,500 1,000 500 5000
Equip. cost (RM000’s) 90 30 20 10 150
Equip. replacement 120 50 30 20 220
cost (RM000’s)
No. of stores req. 300 200 250 50 800

Prepared by: Gerald Peries 19

The following overhead expenditure is forecasted for
the next quarter:-

RM
INDIRECT MATERIALS
- Cost Centre 1 130,000
- Cost Centre 2 24,000
- Cost Centre 3 34,000
- Cost Centre 4 17,000
INDIRECT LABOUR
- Cost Centre 1
40,100
- Cost Centre 2
17,000
- Cost Centre 3
19,700
- Cost Centre 4
15,400
Prepared by: Gerald Peries 20
 PRODUCTION OVERHEAD
EXPENSES (Continuation)
RM
Premises rental 15,000
Premises repairs &maintenance 7,500
Premises insurance 1,000
Electricity for premises 2,500
Equipment depreciation 9,000
Equipment insurance 1,320
Storekeeping costs 6,400

Prepared by: Gerald Peries 21

 ALLOCATED OVERHEADS
(RM)
COST BASIS TOTAL CC1 CC2 CC3 CC4
ALLOCATED
O.H.
Indirect Mat. Direct 205,000 130,000 24,000 34,000 17,000
Indirect Labour Direct 92,200 40,100 17,000 19,700 15,400
TOTAL 297,200 170,100 41,000 53,700 32,400
ALLOCATED
O.H.

Prepared by: Gerald Peries 22

 APPORTIONED OVERHEADS
(RM)
COST BASIS TOTAL CC1 CC2 CC3 CC4
APPORTIONED O.H.
Premises Rental Fl. Area 15,000 6,000 4,500 3,000 1,500
Premises Repair & Fl. Area 7,500 3,000 2,250 1,500 750
Maintenance
Premises Insurance Fl. Area 1,000 400 300 200 100
Electricity for Premises Fl. Area 2,500 1,000 750 500 250
Equipment Depreciation Equip. Cost 9,000 5,400 1,800 1,200 600
Equipment Insurance Rep. Value 1,320 720 300 180 120
Storekeeping No. of Req. 6,400 2,400 1,600 2,000 400
Tot. Apportioned O.H. 42,720 18,920 11,500 8,580 3,720
Tot. Allocated O.H. 297,200 170,100 41,000 53,700 32,400
TOTAL O.H. 339,920 189,020 52,500 62,280 36,120

Prepared by: Gerald Peries 23

 SHARED COSTS OF
SERVICE DEPTS.
➢ SERVICE DEPARTMENTS like
stores & maintenance, etc. do not
produce any product/service
➢ But are required to provide support services
to production depts.
➢ Their cost is also part of overheads
➢ These costs must be charged to the
production depts. on an equitable basis.

Prepared by: Gerald Peries 24

 FULL COST

 The full cost of an object is equal to its

direct cost plus indirect costs.

 Indirect costs are allocated based on the

usage of a chosen cost driver.

Prepared by: Gerald Peries 25

CLASSIFICATION OF COST
DRIVERS
Can be classified as either:
 Volume drivers – e.g. depends on labour
hours; machine hours or units of output.
 Activity drivers – based on attributes
other than volume i.e. activities, e.g.
– Inspection time
– No. of Set-ups for machine
– No. of ATM transactions

Prepared by: Gerald Peries 26

ALLOCATION PROCESS OF INDIRECT
COST ALSO CALLED OVERHEAD
ABSORPTION RATES (OAR)
➢ Once total overheads for each production
cost centre is determined.
➢ The total overheads must be calculated for
each cost unit
➢ This is to be charged to or absorbed by the
cost unit

Prepared by: Gerald Peries 27

CALCULATION OF INDIRECT
COST RATE OR OAR
 INDIRECT COST RATE OR OAR =
BUDGETED OR PAST PRODUCTION O.H
BUDGETED OR PAST COST DRIVER OR ACTIVITY
LEVEL
Frequently used activity level/cost drivers

➢ Direct labour hours or man-hours

➢ Machine hours

Prepared by: Gerald Peries 28

 EXAMPLE OF INDIRECT COST RATE
OR OAR CALCULATION
The following budgeted data was collected for Gemilang
Company:-

Production overheads $10,000

Direct labour hours 2,000 hours
Direct labour costs $ 8,000
Machine hours 4,000 hours
Direct materials costs $ 5,000
Output 2,500 units
Calculate overhead absorption rate or indirect cost
rate using the following common cost drivers:-
A. Direct labour hours
B. Machine hours

Prepared by: Gerald Peries 29

 SOLUTION TO EXAMPLE
 Based on direct labour hours.
 OAR = Budgeted Overhead
Budgeted Direct Labour Hours

= $10,000
2,000 Direct labour hours

= $5 per direct labour hour

If a job requires 10 labour hours, then overhead

charge for the job will be:-
10 hours x $5 = $50

Prepared by: Gerald Peries 30

SOLUTION TO OAR EXAMPLE
 Based on machine hours.
 OAR = Budgeted Overhead
Budgeted Direct Machine Hours

= $10,000
4,000 machine hours
= $2.50 per machine hour

If a job requires 4 machine hours then the

overhead charge for the job will be:-
4 hours x $2.50 = $10

Prepared by: Gerald Peries 31

 EXAMPLE : DETERMINING FULL
COST & SELLING PRICE
The following data was budgeted in January
for Tepat Company:-
RM
 Direct Materials 3,000
 Direct labour 6,000
 Production overhead 6,000
 15,000

Prepared by: Gerald Peries 32

 CONTINUATION
 A total of 500 man-hours have been budgeted in
January. The details of Job 1 and Job 2, amongst
other jobs completed, are as follows:-
 JOB 1 JOB 2
 Direct materials RM 400 RM 500
 Direct labor RM 700 RM 600
 Man-hours 80 100

Prepared by: Gerald Peries 33

 REQUIRED :-
 Using man hours as a basis of
absorption, calculate the selling price
for Job 1 and Job 2. The company’s
normal practice is to add 20% to the
production cost to cover the selling and
admin. expenses. The selling price is
determined by adding a 30% mark-up
to the total cost.
Prepared by: Gerald Peries 34
 SOLUTION
 Calculate the Overhead Absorption Rates
 Overhead Absorption Rate
 = RM6,000/500 man-hours
= RM 12 per man-hour

Prepared by: Gerald Peries 35

 SOLUTION (CONTINUATION)
JOB 1 JOB 2
RM RM
Direct materials 400 500
Direct labour 700 600
Production overhead 960 (80 x RM12) 1,200(100 x RM12)
Production cost 2,060 2,300
Add selling & admin.(20%) 412 460
TOTAL COST 2,472 2,760
Add mark-up (30%) 741.60 828

PRICE: RM3,213.60 RM3,588

Prepared by: Gerald Peries 36

 ACTIVITY BASED COSTING
(ABC)
➢ A technique for determining the O.H. for each cost
centre based on activities
➢ Traditional Absorption Costing allocate &
apportion O.H. to cost centres
➢ These O.H. are then absorbed by the cost units
using a volume based activity like labour hours or
machine hours

Prepared by: Gerald Peries 37

 ACTIVITY BASED COSTING
(ABC) (Continued)
➢ O.H. Costs are grouped according to
what drives these costs (Cost drivers)
➢ Cost drivers are used as a basis of
absorbing O.H. costs to
products/services.

Prepared by: Gerald Peries 38

 EXAMPLE OF ACTIVITIES &
COST DRIVERS
ACTIVITY COST DRIVER COST PER
DRIVER
Set-up Cost No. of Set-Ups Cost per set-up
Inspection Cost No. of Inspections Cost per inspection
Cost of No. of orders Cost per order
Handling Orders
Cost of No. of ATM Cost per ATM
Providing transaction transaction
ATM Service
Processing Cost Processing time Cost per Hour
Prepared by: Gerald Peries 39
 EXAMPLE OF ABC
Golden Industries manufactures two types of vacuums, Model X and
Model Y. The manufacturing process for the two models is very
similar. The following details the product data for these two models
for next year:-
MODEL X MODEL Y
Units produced 5,000 7,000
Direct labour hours per unit 1 2
Direct labour rate per hour $5.00 $5.00
No. of set-ups 10 40
No, of orders 15 60
Machine hours per unit 3 1
Materials per unit 10 kgs 5 kgs
Material cost per kg. $2.00 $3.00

Prepared by: Gerald Peries 40

ABC EXAMPLE (CONTINUATION)
OVERHEAD COSTS:-
$
Cost of setting up machine 20,000
Cost of handling orders 45,000
Machining cost 220,000
TOTAL OVERHEAD COSTS : 285,000
========
Other Information
The co. adds $4 for model X & $5.50 for model
Y to cover selling & admin. expenses.
Selling price is determined by taking a mark-
up of 30%on total cost.
Prepared by: Gerald Peries 41
SOLUTION TO ABC EXAMPLE
ACTIVITY COST COST
DRIVER PER DRIVER

Machining Costs Machine Hours $220,000/22,000 hrs

= $220,000 = 22,000 hrs = $10
Set-up Costs No. of set-ups $20,000/50 set-ups
=$20,000 = 50 = $400

Order Costs No. of orders $45,000/75 orders

=$45,000 = 75 = $600

Prepared by: Gerald Peries 42

 DETERMINING OVERHEAD
COST PER UNIT
($) ($)
MODEL X MODEL Y
Machine Costs
(5,000 unitsx3hrsx$10)150,000 (7,000unitsx1hrx$10) 70,000
Set-up Costs
(10 x $400) 4,000 (40 x $400) 16,000
Order Costs
(15 x $600) 9,000 (60 x $600) 36,000
TOTAL OVERHEAD
COST: 163,000 122,000

OVERHEAD COST
PER UNIT = 163,000 122,000
5,000 units 7,000 units
= $32.60 $17.43

Prepared by: Gerald Peries 43

 TOTAL COST & SELLING PRICE
USING ABC
($) ($)
MODEL X MODEL Y
Direct material
(10kgs x $2) 20.00 (5kgs x $3) 15.00
Direct labour
(1 hour x $5) 5.00 (2 hours x $5) 10.00

Overhead 32.60 17.43

Production Cost 57.60 42.43
Selling & Admin exp. 4.00 5.50
Total Cost 61.60 47.93
Mark-up (30%) 18.48 14.38
Selling Price 80.08 62.31
===== =====
Prepared by: Gerald Peries 44
END OF MODULE 2

Prepared by: Gerald Peries 45